James d. Gwartney

Use Insurance to Protect Yourself
Life involves risks. The risks of life range
from the small and financially insignificant,
like receiving poor service at a restaurant,
to the large and financially devastating,
such as a severe illness or having your
home destroyed by a tornado. While you
cannot eliminate risk, you can take steps to
reduce and manage it.
You can make choices that will
reduce risks. Not texting while driving
reduces the chance of being involved in an
accident. Wearing a seatbelt lowers the
chance of injury if you are involved in a
collision. Installing smoke detectors and a security system decreases the likelihood of your
residence burning down or getting burglarized. Decreasing sugar consumption and eating low-
cholesterol foods reduce the chance of illness and disease. While your choices can reduce risk,
it can never be totally eliminated.
How can you manage risk and protect yourself from the most adverse consequences?
Insurance can reduce the financial loss resulting from damages to possessions (such as your
home or car), an illness, loss of income, or other harmful events. Insurance provides a way for
a group of people to pool payments and share risks in order to offset the losses of members
actually damaged by an adverse event. The principle of sharing risk is often forgotten because
individuals pay premiums to an insurance company and have no interaction with the group
members. The insurance company is an intermediary, or middleman, in the risk-sharing
process. The company collects premiums from each member of the group (its policyholders),
then disburses payments when a covered loss occurs.
ELEMENT 4.12

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To understand how risk sharing works, imagine the following situation. You and four
associates go to a restaurant for lunch and expect that the total bill will be €100. The five of
you agree to instruct the waitress to randomly give the check to one of you at the end of the
meal and that person will pay the entire amount. You and the other group members can then
choose between two options: (1) take a chance, and hope you are not selected to pay the €100
bill; or (2) pay a premium of €20 to an insurer, who will pay the €100 bill if you are selected.
Many people will prefer option 2 because it is less risky. While you have to pay the €20
premium, you protect yourself against the 20 percent possibility of having to pay the entire
€100 bill.
Of course, insurers providing the risk-sharing service incur costs. They will have to
assess risks, formalize agreements, collect premiums, examine and validate claims, and
process payments. These handling and processing costs will have to be covered, in addition to
the costs of the risk. Thus, the insurance premiums will have to be somewhat higher than the
expected costs of the loss. For example, if an insurance company were going to provide
members of our lunch group with protection against the 20 percent chance they might end up
with the €100 bill, it would have to charge each a little more than €20, perhaps €22, in order
to have an incentive to offer the service.
Insurance reduces risk because it spreads the burden of unfortunate events that a few
people experience over a larger group of people. In the lunch situation, the €100 bill is coming
with certainty. The uncertainty comes from not knowing which member of the group will
receive it. A larger group will increase the amount of the potential loss, but it will also reduce
the chance of any individual member receiving the bill.
When it comes to large sums, most of us are risk-averse. That means we are willing to
pay a premium in order to reduce the adverse consequences of various events. Buying
insurance is one way of reducing exposure to risks. An easy way to see why this is so is to ask
yourself if you would accept a bet that paid you €1,000 if a fair coin
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came up heads but
would make you pay €1,000 if tails came up. Most of us would not take such a bet even
though it is “fair” in currency terms. Why not? You must value the things you would have to
give up (not purchase) if you lost the bet more than you value those you would buy if you won.
This is clear because without the bet you chose the first group over the second one.

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Insurance, however, is not always cost-effective. You should think carefully about
whether it makes sense for you to insure against a risk. Yes, you should insure against events
that, if they occur, will impose severe financial hardship. A severe illness that prevents you
from working for an extended period of time, a car accident, or a flood that damages your
home are examples. Insuring against relatively small adverse events such as a breakdown of an
appliance or television is generally not cost-effective. Providing the risk-sharing service will be
expensive relative to the potential harm. Thus, it will generally be more economical to accept
these risks and use a rainy day account (see Part 4, Element 6) to plan for and cover the cost of
these risks. In contrast, automobile, housing, and healthcare insurance are usually cost-
effective. In these cases, the cost of spreading the risks over a group of people is generally low
relative to the potential damages of an adverse event. We now turn to those topics.
Many countries require car owners to maintain some level of automobile insurance.
Make sure to check with your insurance company so that you meet the minimum requirements.
Customers will pay a premium based on a number of factors. Those include the driver’s record,
characteristics of the driver, the type of automobile, and the specific coverage limits and
deductibles of the policy. A deductible is the amount the customer must pay first before any
insurance coverage applies. For example, a €500 deductible means the customer must pay
€500 before the insurance policy will pay for a loss. Generally, the higher the deductible, the
lower the premium. Coverage is the maximum amount the policy will pay in the event of a
loss.
An auto policy is typically structured with a few basic coverages, or types of loss.
Collision pays for damages to your car in the event of an accident. Comprehensive pays for
non-collision damages such as theft, vandalism, and acts of nature like a tree branch falling on
your windshield. Liability coverage, sometimes known as Motor Third-Party Liability
(MTPL), comes in two forms. First, it pays others for damages to their person or vehicle
caused by the operation of your automobile. Second, it pays damages to you and your
passengers for medical expenses and death benefits. For example, liability coverage of
€500,000 means the most the insurance will pay in the event of a loss is €500,000, even if the
actual loss is greater. When purchasing insurance, you should consider carefully the size of
your coverage limits and deductible levels. Do you have enough in your emergency account or

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other funds to pay the deductible?
As discussed in Part 4, Element 11, housing is the largest investment most people will
make. It makes sense to insure against the loss of your biggest asset. Sometimes it is required
to have some level of insurance, mandated by country regulations or the financial institution
holding a mortgage that financed your purchase. Make sure to consult with your insurance
company so that you are meeting the required minimum standards. Similar to auto policies,
housing insurance will have deductibles and coverage limits. As in the case of auto insurance,
if you choose a higher deductible, your premiums will generally be lower. You should carefully
analyze how much risk to bear yourself.
Healthcare insurance varies a lot by country, and can be a complicated issue because of
the financing and payment methods for customers and the variety of plans available. Some
people are insured by their country’s government, and they may or may not be able to choose
additional private coverage. Some people obtain their insurance through their employer while
others buy directly from an insurance company. Some people pay all of their premiums while
others have third parties pay (for example, the government or employer). Plans vary,
depending on who pays and what is covered. In the United States, the Patient Protection and